I used to only send out quarterly reports, but these days much changes in a few days. We began our saga two weeks ago, and in our September 9 update I listed a group of financial companies in serious trouble. Most went out of business the following week. Now, as we all know, the Treasury Department and Federal Reserve Board have decided they need to bail out the entire credit industry. Yesterday Treasury Secretary Henry Paulson and Fed Chairman Bernanke spoke to Congress, who did not receive their plan particularly well. Hopefully they will be able to agree on a plan very soon.

Senators complained that the three page bill being proposed basically gives Mr. Paulson nearly autocratic control over our financial companies. Plus, the bill does not guarantee certain things that many people consider important, such as executive compensation, and making sure that homeowners who can pay a reasonable mortgage don't lose their homes. Plus, does anyone think we should have someone buying $700 billion worth of anything without any oversight?

While I agree that some of these details need to be filled in, the fact is that the people in charge of this bailout must be able to act quickly and flexibly when needed. But most importantly, I am fairly certain that doing something like this bailout may be the most likely way to avoid economic calamity.

In order to understand why this particular type of bailout is necessary, a person needs to realize that the largest and most imminent problems to our financial system are due to the massive use and misuse of credit default swaps (CDS), a type of derivative financial product designed to guarantee bonds - mostly mortgage-backed bonds. Five years ago Warren Buffett called them a "time bomb" and "financial weapons of mass destruction," and he had his insurance companies leave the credit default swap market. Mr. Buffett said this market would most likely collapse at some point, and last Monday it nearly did just that.

It is difficult to conceive of how large this CDS market became over the last few years. It is estimated to be over $70 trillion. This is nearly the size of all the money in all the banks in the world. And this financial structure was built upon our mortgages, such that the $70 trillion monstrosity was nearly certain to fall if our real estate market ever got into trouble. AIG had to be bailed out because, according to their CEO, they could not continue to keep up their end of all the CDS trades once Lehman had failed. AIG assured the Fed that, if they fell, a large number of major financial institutions around the world would all topple. As we know, the Fed then gave AIG $85 billion to prevent this. But last week Morgan Stanley may have started to crack under the pressure of their CDS obligations. If Morgan Stanley had fallen, we would have had panic in this country. To prevent this, Treasury and the Fed entered in to try to fix the underlying problem with their bailout. If they fail, $70 trillion worth of these credit default swaps will crash on our financial system.

Fortunately, the new plan should have a good chance of success. The underlying problems are the mortgages, as the credit default swaps are mostly guaranteeing residential mortgages. This plan should work because it will offer at least a modestly more profitable way to dispose of the troubled mortgages. It will also create a market for the pools of mortgages. Finally, it will give all the financial institutions time for the problems to work out. With time, most of the mortgages should turn out to be either profitable or have limited losses. This then eliminates most of the credit default swap risk based upon these mortgages.

Time was clearly not on their side last week, and the entire financial system was seizing up. This means that nobody would finance anyone else. Unfortunately, without constant financing the investment banks cannot last a week, and several didn't. But the government is the one financial entity that has money and won't go away (to the chagrin of many!). Their intervention thereby stabilizes the situation and should give companies confidence that they can continue to do business with each other and the public.

While this bailout should protect us against an ongoing financial crisis, even if it works, this hardly leaves the U.S. economy in great shape. Given this, many understandably wonder why a person would want to own any U.S. stocks. In my next quarterly letter, I will explain in some detail why it is still a good time to own the best stock-based investments. Of course, perhaps the best way to maintain a balanced and opportunistic view on investing during dangerous times is to watch and listen to Warren Buffett. Last night he announced that he was investing $5 billion into Goldman Sachs. Now for the last two weeks I have been singing Goldman's praises. Last week's update said, "I guarantee you Goldman Sachs is the prize. They are by far the best, in profits, judgment, risk control, etc., etc. There isn’t a second in their group." And the previous week's update said, "So while this is terrible news for those who own Lehman Brothers’ stock, which went down 45% on Tuesday, this may be great news for their competitor Goldman Sachs, as Goldman did not engage in any of the ill-advised activities Lehman undertook. As a result, coming out of this mess, Goldman will be able to grow and take over much of the market share left behind by inferior companies such as Lehman." I wanted to buy Goldman stock myself last week, but I find it best to leave a decision like this to Mr. Buffett, who knows the CEO of Goldman Sachs and who is the safest, most successful investor in financial services over the last 50 years.

Mr. Buffett's answer as to why he put $5 billion into Goldman last night is essentially my answer as to why we want to continue to own stock funds:

"We had a lot of cash, and we are now seeing things that give us a chance to use that cash sensibly," Buffett told CNBC television, referring to holdings at Berkshire Hathaway." Five years from now, ten years from now, we'll look back at this period and we'll say you could have made some extraordinary buys," he continued. "The American economy over a period of time will do very well, and people that own a piece of it will do very well."

This may sound hard to believe today, but current events have once again demonstrated that Mr. Buffett is pretty much always right about the big things. He is calm and optimistic when others are afraid and desperate. Berkshire Hathaway stock has gone up 11.48% since our turmoil began, and Mr. Buffett has another $30 or so billion to invest. I believe his purchases will generate large returns for us, and continue to be the safest stock investment in the country - along with a number of our other stock-based mutual funds.

Richard Morey
Secure Retirement
18 Crow Canyon Court
Suite 300
San Ramon, CA 94583
925-855-4300